Most countries saw huge spikes in CPI inflation throughout 2021 and 2022, driven by surging energy costs and higher commodity prices.
Oil prices impact on petrol prices, which are included in the CPI and can change dramatically – therefore having the dominant impact on CPI inflation.
The chart below tracks US annual CPI inflation and annual oil price inflation advanced or leading by one month. You can clearly see in the chart that this source of inflation has retreated dramatically, contributing to lower CPI inflation.
As central banks around the world continue to battle inflation, hiking interest rates to depress economic growth, part of the fallout should be lower commodity prices and likely lower oil prices. If so, this source of inflation will abate further and mean lower CPI inflation in most countries, including NZ.
However, for the first time in over 25 years, while US CPI inflation is slowing thanks to lower oil price inflation, it’s still running well above the level it should be if oil prices were the main driver. Given US oil price inflation has fallen to near zero, if the relatively close link that existed previously had continued, CPI inflation should have fallen to around 1.5%, far below the most recent reading of 6.5%.
The implication is that there’s something else boosting inflation.
Other factors at work in the last couple of years have included Covid-related supply disruptions and Russia’s invasion of Ukraine, which has contributed to diesel prices rising relative to petrol prices. But neither explain the scale of the gap in the first chart.
Then there’s the growing cost of labour. In a modern economy, labour is the largest cost for most industries. The chart below compares US core consumer price inflation (based on the personal consumption expenditure price index, excluding food and energy costs) with annual unit labour cost inflation (being the labour cost per item produced).
Some behavioural changes among workers since Covid are partly behind this higher unit labour cost inflation. But the main cause is central banks and governments stimulating economic growth too much after Covid, boosting employment and driving down unemployment rates below levels consistent with low inflation.
This gave workers and unions greater bargaining power, and they’re making use of it.
All of these factors have seen CPI inflation grow to well above the levels central banks are tasked with targeting, and subsequently set off wage price spirals in most countries including NZ. Workers make use of the increased bargaining power to get high pay increases and other benefits, then businesses respond by putting prices up more, undermining the value of pay bumps and leading workers to seek further increases.
This is the real challenge facing central banks, and generally speaking, it takes a reasonably sustained period of high interest rates and a recession to break a wage price spiral.
However, this doesn’t rule out temporary falls in interest rates as the economic fallout from the large interest rate increases become evident.
By Rodney Dickens, Managing Director, Strategic Risk Analysis Ltd www.sra.co.nz.